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Recognition shock

The wave of anti-establishment, anti-globalization sentiment, evident in the U.S. primary election cycle, manifest itself bigtime in the U.K. with its vote on Thursday, June 23rd, to exit the European Union (E.U.).  Wall Street hates uncertainty; that is why it loves the status quo.  In the days leading up to this historic British decision, the markets were so confident that the vote would be to “remain” in the E.U. that almost all of the world’s equity exchanges, in love with the status quo, were moving significantly higher.  In the 7 prior trading sessions, ending on Thursday, June 23rd, the S&P 500 had moved up more than 2%.  The German and French exchanges rose nearly 8% in the prior 8 trading sessions, with the British market advancing about 7% over that same period.  The upward movements had occurred because the British polls, while close, were showing the “remain” camp would prevail.  To say the actual result was a “shock” would be an understatement.

U.S. Markets More Impacted Than European Markets

In reality, on Friday, June 24th, nothing had yet changed in the British economy.  In fact, under the E.U. agreements, the U.K has up to two years (or longer if both parties agree) to negotiate the terms of its exit.  And, in fact, at the end of Friday’s European trading, while all of the markets sold off, the French equity market ended up only 0.6% lower than its starting point 8 sessions earlier (June 14th), the German market was up 0.4% from that same June 14th starting point, and, amazingly, the British market, while it did close down 3.2% from its Thursday close, was still 3.6% above its June 14th level. It was the U.S. market that took it on the chin.  Having advanced about 2% during that pre-celebration period, it lost 3.6% on Friday, to close 1.6% lower than its starting point (June 15th).  Monday (June 27th) is another day, and we shall see then if the European markets can hold up.

It isn’t quite correct to say that nothing had changed in the British (or world) economy(ies).  What had changed was the vision of what the E.U.’s economies might look like in the future – and whether or not other members would get restless.  That is, there now is recognition that the status quo will change – I call this “recognition shock,” and, in this case, the financial markets don’t like it.

The Economic Arguments

I have examined many of the economic arguments about why Britain will suffer if they exit (including severe recession), and find few of these credible.  It’s not like trade between the U.K. and the E.U. will cease.  In fact, the U.K. will be freer to negotiate trade deals than it is today under E.U. rules, and likely will end up with better ones.  The only real short-term economic question is whether or not Brexit itself will have psychological consequences on the population and businesses which might negatively impact consumption and investment decisions. Let me be the first to point out that Brexit psychology may actually have a positive impact.

Due to the unexpected shock of Brexit, we can expect higher levels of market volatility, at least for a week or two, and a move toward safer haven assets, including the dollar and U.S. Treasury securities.  If there is a dramatic and permanent strengthening of the dollar as a result of the flight to safety, there could be a renewed negative impact on U.S. manufacturing exports, but worse, it could start another round of currency devaluations (especially, the Chinese yuan).  Whether or not any of this occurs is highly speculative, and really not worth more than a mention so that we are cognizant of the possibilities.  Once the markets accept Brexit as a reality, volatility will calm, and the move toward safer haven assets will likely reverse.

Recognition Shock at the Fed

Recognition shock also occurred at the Fed in mid-June.  Economists have always relied on historical patterns when analyzing data or making forecasts.  Not anymore!  Since the Recession, there have been epic changes in the way people move around, spend money, borrow money, get married, have children, etc. and this, together with the aging population, has played havoc with economic modeling, expectations, and market volatility.  We have had zero interest rates for 8 years, and the Fed, using models based on historical data, has been consistently wrong about the future path of the economy.  As a result, it has, of late, roiled markets with its threats of raising rates.  Suddenly, in June, after 7 years of faulty forecasts, they have finally recognized that future economic growth will be slower than what their models were predicting, and, therefore, interest rates will be lower for longer.  Going forward, we can expect less volatility around Fed meetings, as it is more likely that Fed economic forecasts will more closely mirror what the market sees.  It appears that the Fed and markets are now in agreement that 1-2% growth is the “new normal” for the U.S.

Recognition shock is rare. Sometimes it roils markets and increases volatility, like Brexit.  Sometimes it calms markets and reduces volatility, like the Fed’s recognition of the new normal economic growth rate and the consequences for future interest rates.

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